Some smaller emerging economies have seen rising inflationary expectations in recent months coupled with stronger evidence of recovery and a bias away from further monetary loosening. This is creating a kind of dichotomy within EM monetary policy, and it encapsulates three of the central themes in today's markets:

The effort to loosen policy in BIC could have important implications globally simply by virtue of their sheer size. Citi's global research shows Brazil, India and China make up 17% of global GDP and crucially, 49% of forecast global GDP growth in 2012.

The case for China

Considering that global confidence is, in part, China-dependent, the prospect of looser Chinese monetary policy could support global confidence and help intensify the pressure on other EMs to tighten policy. Or it could put pressure on Brazil to take further measures to stem the pressure on the Brazilian Real (BRL) to appreciate.

Chinese loosening is expected, but will most likely come in a constrained way given the ambiguity these days about just how pressing China's need for policy loosening actually is. There are signs that things are not so gloomy - fixed asset investment maintained a growth rate above 21% in January-February, and property investment rose by 27.8%. In addition, the tone of government-related research institutes is relatively bullish, arguing that government spending will support demand in 2012 particularly as investment projects from the 12th five year plan are implemented.

The issue that Citi analysts find most interesting is whether Chinese credit market developments might be heightening the need for more aggressive loosening. A key factor here is the increased credit-dependence of Chinese growth. Citi analysts note that Chinese efficiency has declined, with China needing more units of investment and credit to generate a given unit of GDP compared with the pre-Lehman period. With this in mind, it may be worrying that China's credit markets show signs of stress. Liquidity is constrained as a result of reserve requirement ratio (RRR) increases in 2010 and 2011, as well as insufficient RRR cuts when smaller net capital inflows reduced the external sources of liquidity creation.

The access banks have to funding has been squeezed because of competition - including competition from wealth management products, and as a result, money growth rates have fallen sharply. This may be partly behind the decline in new lending activity. The increase in total social financing (TSF - a broad measure of credit extension) reached 2.0 trillion Renminbi (RMB - the official currency of the People's Republic of China) in January-February 2012, versus 2.4 trillion in January-February 2011.

Citi analysts expect monetary and regulatory policy to ease in the next few months including cuts in the RRR as well as a loosening of the loan-deposit ratio restrictions. Another form of loosening could come through the exchange rate. Chinese policymakers are increasingly converging on the view that the RMB is close to its equilibrium value given the decline in the current account surplus last year to just under 3% (from an average of 6.8% 2004-2010). Although Citi analysts think China's fundamentals still support slow RMB appreciation, they believe policymakers' instincts are likely to favour a relatively weak exchange rate if the economy needs support.

Spotlight on Brazil

Further Brazilian loosening looks set to focus on the exchange rate more than interest rates. Brazilian nominal and real interest rates have fallen in recent months - the Selic (the overnight lending rate) has reached 9.75% down from 12.5% last summer.

However, Citi analysts believe the most visible form of policy loosening may lie in the Brazilian authorities' efforts to prevent the exchange rate from strengthening. The 6% tax on foreign exchange transactions has been extended to foreign loans with maturities up to five years, and further extensions are possible. Still, Brazil's effort to achieve depreciation is likely to entail greater tolerance by policymakers towards potential deviations to their inflation target and rise in spreads relative to other EMs.

...and in India

While the prospects for different forms of easing in China and Brazil seem straightforward, the case in India has shifted recently thanks to rising price pressures - in February CPI rose to 8.8% up from 7.6% in January. The Reserve Bank of India's (RBI) policy statement on 15 March emphasised these residual inflation risks in spite of India's growth deceleration. In this context, Citi analysts have revised their interest rate forecast. They now expect only rate cuts of 0.5% to 0.75% instead of 1.0% previously.

Away from BIC, things are looking stronger

A hint of the dichotomy between 'big' and 'small' is contained in the Organisation for Economic Co-operation and Development's (OECD) leading indicators. These suggest that Brazil and China are faring poorly while Indonesia, South Africa, Poland and Mexico seem to have relatively brighter prospects. India, interestingly, has an OECD leading indicator which does not particularly point to slowdown risks, and this fits well with the earlier point that the chances of aggressive Indian monetary loosening have diminished.

Inflation expectations have also shifted up recently, albeit modestly, in a number of countries. Citi analysts note that expectations have risen in Chile, Colombia, Israel, Poland and Mexico; have stayed flat in Korea; and have fallen in Brazil.

Meanwhile, higher inflation expectations have helped to push up yields. Given all the factors discussed here - stronger data, cost-push pressures and rising inflation expectations, interest rate cuts are being priced out in a number of countries. And more recently, this rise in EM yields has been given an additional push by the rise in US yields. Considering that EM yields have generally been sensitive to US yields, any further upward pressure on US yields is likely to maintain pressure on many rates markets in EM.

The bottom line is that EM interest rate markets and monetary policy are likely to remain data-sensitive, and sensitive to both the US and China. For the small countries, upward pressure on inflation expectations seems to be the order of the day. One risk to this view is the market's capacity to be shocked by weak Chinese data. Since Citi analysts think that China's willingness to loosen policy may be postponed until weaker data become more apparent, China might present the biggest source of policy uncertainty for EM at the moment. The direction of policy seems clear there, but not the timing.